One of the major causes of stock market losses is unforeseen declines that make people sell out—often at the worst time. This is one of the reasons I’ve focused much of my recent research on using drawdown (instead of return variance) as a measure of risk. In my opinion, it provides a better metric for real-world investment performance.
A good deal of data supports this idea. Studies have shown that, because they tend to move in at highs and out at lows, individual investors perform worse than the actual markets or funds. You can’t really do that much about buying in at highs, but you can look at ways to mitigate the downdrafts, reducing your likelihood of getting scared out of the market at the wrong time.
Moving averages as warning signals
I’ve written before about using moving averages as a market weather-forecasting system. It works most of the time, in the sense that it can help you reduce downside exposure—at the potential cost of lower returns in a bull market.
After discussing this with a number of Commonwealth advisors, I’ve realized that much of the value can come not from trying to trade around the market, but simply from being prepared for difficult times. It’s like the difference between a hurricane, which you may know is coming, and an earthquake, which comes as a surprise. Both are bad, but forewarning can make a very positive difference.
A look at my research so far
These numbers are quite preliminary, but I wanted to see just what the maximum drawdowns were when moving average trends were broken. For test purposes, I used 5-month (or roughly 100-day), 10-month (or roughly 200-day), and 20-month (or roughly 400-day) moving averages. There is a trade-off between how quickly you react and how often you trade, so these are reasonable starting points. I used monthly data for the S&P 500, looking at maximum drawdowns over the next one, three, and five years from when the moving average trend was broken.
Based on a first look at the data, breaking any of the moving averages leads to significantly higher drawdowns over any of the time periods than otherwise. In other words, breaking the 100-day, 200-day, or 400-day moving averages suggests that any drawdown over the next 1-, 3-, or 5-year period is likely to be significantly worse than otherwise. Moreover, the maximum drawdowns get worse the longer the period of the broken moving average is, and they get worse over longer time periods.
What does this mean for investors?
Breaking a moving average can signal a weakening of the market, which may continue for years. It doesn’t necessarily indicate a short-term decline, but it does change the trend of the market.
As of today, we’ve had several breaks of the 5-month or 100-day moving average over the past year or two, which suggests the possibility of weakness ahead. We haven’t had a break of the 10-month moving average since late 2011, but we’re still in the danger zone from that one. Investors should be prepared for, and not surprised by, market weakness. Personally, I’ll start to pay attention the next time we break the 100-day moving average, and I’ll get concerned when we approach the 200-day average. We’re still well above those levels, but forewarned is forearmed.
Overall, while the market continues to run higher, signs of weakness exist and suggest caution going forward. I’ll be spending more time analyzing these signposts and reporting back as I go.